What Is Net Present Value (NPV)?
Net present value measures how much value an investment creates in today's dollars after accounting for what it costs. It works by discounting every expected future cash flow back to the present at a rate reflecting the investment's risk, then subtracting the initial outlay.
The decision rule is simple: accept projects with positive NPV, reject those with negative NPV, and be indifferent at zero. This makes NPV the gold standard of capital budgeting because it directly measures dollars of value added.
Formula
NPV = sum of CFt / (1 + r)^t for each period t, minus the initial investment, where CFt is the cash flow in period t and r is the discount rate. A DCF valuation is essentially an NPV calculation applied to an entire company, and the discount rate that sets NPV exactly to zero is by definition the investment's internal rate of return.
Example
Suppose a project costs $1,000 today and returns $500 at the end of each of the next three years, with a 10% discount rate. The present values are $500 / 1.10 = $455, $500 / 1.10^2 = $413, and $500 / 1.10^3 = $376, which sum to $1,244. NPV = $1,244 - $1,000 = $244, so the project creates $244 of value and should be accepted. At a 25% discount rate the same cash flows are worth only $976, giving an NPV of -$24 and a rejection.
Why It Matters
NPV is the foundation of rational investment decisions across corporate finance, from factory expansions to acquisitions, because it accounts for both the timing and the risk of cash flows in a single dollar figure. Unlike IRR, it handles unconventional cash flow patterns cleanly and always ranks mutually exclusive projects correctly by value created.
Interviewers may ask when NPV and IRR give conflicting answers, and the standard response is that NPV wins because it measures absolute value creation rather than a percentage return.
